KEY TAKEAWAYS
- Global growth optimism—which had been picking up steam on the back of positive developments around both Brexit and the US-China trade conflict—has been severely dampened by the impact of the coronavirus outbreak.
- EM valuations have been significantly battered across the board, while DM equities have remained remarkably resilient.
- Even considering the obstacles, we believe global growth rates will continue to improve.
- We’ve revised our outlook for the possibility of central bank easing, thinking the Fed’s continued emphasis on below-target inflation may make further cuts more likely.
- Given the precipitous drop in valuations that belie the underlying positive fundamentals, we continue to believe that EM is the most attractive sector in fixed-income.
The global economy just doesn’t seem able to catch a break. Right as trade tensions and Brexit uncertainty declined, the coronavirus and the challenging efforts to contain it threaten to derail or at least postpone any pick-up in the global recovery. This has been challenging for market participants as the early economic data this year suggested the possibility that the recovery was improving. Markets quickly repriced to a more positive global outlook, even without decisive evidence that the global manufacturing weakness was ending. With China’s growth rate now being revised sharply lower in the first quarter and thereby meaningfully lower for the full year, the diminished global growth outlook has caught investors offside. US Treasury and developed government bond markets around the world have rallied sharply. Emerging market (EM) currencies, stocks and bonds have been pummeled. Developed market (DM) equities have held up surprisingly well, buoyed by even lower interest rates and perhaps the prospect of further central bank stimulus.
Even if the global recovery has been merely retarded rather than derailed, the weaker outlook and shallower recovery put a particular focus on two elements of our investment strategy. The first is the prospect for EM debt, a sector we have been championing. The second is the heightened difficulty central banks will face in putting a floor under inflation and inflation expectations, an issue we have highlighted for the length of the post financial crisis recovery period.
We have been constructive on all three forms of EM debt: USD-denominated sovereign, USD-denominated corporate and local currency bonds. The most volatile segment has been local currency debt. Exhibit 1 shows the price performance of the J.P. Morgan GBI-EM Global Diversified Price Index (GBI-EM) since 2010. Note that in a period when DM spread products have done extremely well, leading to yield-spread levels that are at post-crisis tights, the GBI-EM Index is down nearly 40% from the level that prevailed earlier in the decade. It is this extremely low price that helps inform our view that EM is the most attractive sector in fixed-income. EM local currency debt was beaten up by the 2013 taper tantrum. After a minor recovery in 2014, it was mauled by the 2015-2016 global growth fear that saw oil drop to $25 a barrel. At that time, our view was that the substantial cheapness of the sector combined with a prospective global growth improvement would usher in an extended period of outperformance. After a good start in 2017, the worst of all worlds hit in 2018. Not only did EM suffer from the taper-tantrum-like effects of higher interest rates as the Federal Reserve (Fed) tightened policy four times and the dollar rose, but concurrently EM suffered from the fears of a global slowdown as economic growth outside the US was increasingly revised downward. Then in 2019, the reasonable prospect of a bounce from diminished levels was held in check by the risk of a protracted trade war.
This year, EM has turned down again as the result of global growth caution. It is also being challenged by the renewal of the concept of US exceptionalism—that growth in the US will be persistently higher than in other DM economies. These concerns also auger for a higher dollar, creating additional currency pressure. So for those who are sticking with this position, is it simply a stubborn example of hope over experience?
As value investors, we are informed primarily by valuation. The 40% decline in EM prices stands in sharp contrast to the 10-year highs in DM fixed-income sectors. The optimism underlying DM valuations relies upon a sustained global expansion. A global downturn would cause spread-widening stress that would be hardly isolated to EM. Conversely, if the trajectory of global growth once again turns up, the potential outperformance for this sector would be substantial. In the meantime, as the global crosscurrents are being sorted out, the carry advantage of this sector is meaningful. The GBI-EM Index yields 4.77% compared with the Barclays Global Government Index yield of 0.84%.
The decline in EM inflation rates combined with the reversal of Fed policy in 2018-2019 from tightening to easing has given EM economies scope for meaningful monetary stimulus. Our view is that the path of global growth will not only continue to be positive—we believe ultimately that it will turn up.
In light of the possibility of a weaker global growth outlook, DM inflation expectations have fallen further below targets. The long-term fall in inflation breakevens and surveys of inflation expectations further underscore the deepening skepticism that trend inflation can ever be achieved.
In our last note, we highlighted and welcomed the major central banks’ efforts to directly target inflation outcomes. We felt that while the bar to raise short rates in the US was extremely high, the Fed was also unlikely to cut rates without a material shortfall in growth. Recent developments have changed our mind. Particularly instructive are the most recent quotes of Fed Chair Jerome Powell, who has more strongly articulated his determination not to let inflation expectations decline further as the Fed fights to attain its 2% inflation target.
“We have seen this dynamic play out in other economies around the world, and we are determined to avoid it here in the United States.”
“... we’re not satisfied with inflation running below 2% …” – Jerome Powell, October 2019
We now think the Fed’s willingness to ease if inflation disappoints—even if like last year growth remains above trend and financial conditions remain elevated—is much stronger. New York Fed president John Williams suggested as much when he said, “But expectations depend on deeds, not just words …”
We have long maintained that the road to inflation normalization would be protracted and would demand substantial policy support. Over the last 10 years, policymaker and market participant declarations that policy was unduly supportive of accelerating inflation have proved continually mistaken. Finally, the major central banks seem unified in committing to directly take on this heretofore underappreciated challenge.
From our perspective, if words continue to be followed by deeds, the prospects for putting a floor under DM inflation are actually getting better.